The Taylor Rule Could Put Fed on Autopilot

First, AI came for our jobs, now it wants to set monetary policy. With Fed Chair Janet Yellen's first term as the leader of the Federal Reserve Committee coming to an end, there talk President Donald Trump may appoint a new chairperson who would adopt a rules-based policy, essentially turning the Fed into a robot. Setting monetary policy this way would see the Fed adjust interest rates based on key economic indicators such as inflation, GDP, and the unemployment rate.

Welcome to the Taylor Rule

The most popular formula is the Taylor Rule, which would see the Fed set a real fed funds rate, usually 2 percent, and then derive the nominal rate using current inflation, inflation expectations, GDP and GDP expectations. The formula is as follows:

In this equation, itis the target nominal interest rate, πt is the rate of inflation as measured by the GDP deflator, π*t is the desired rate of inflation, r*t is the assumed equilibrium real interest rate, yt is the log of real GDP, and is the log of potential output. Both aπ and ay should be positive, as the rule "recommends" a relatively high interest rate when inflation is above its target or when output is above its full-employment level, in order to reduce inflationary pressure. It recommends a relatively low interest rate in the opposite situation, to stimulate output.

Proponents argue that by adopting a rules-based policy, the Fed will become more transparent and predictable. John Taylor, who introduced the Taylor Rule in 1993 originally said the formula was a basis for explaining Fed policy and how the different components can affect the movement on the fed funds rate. However, in more recent years Taylor has become much more vocal, arguing that the formula should be the benchmark for monetary policy. He cites that interest rates were kept too low from 2003 to 2005, which fueled the housing bubble, and also in the aftermath of the financial crisis, when the Fed kept rates too low for too long—in his opinion—hindering growth.

Critical Opinions

Opponents argue that monetary policy is a tool for human judgment and instinct, not rules and robots. We live in a world where 2 percent inflation today is not the same as 2 percent inflation ten years ago. Globalization, supply chain efficiencies, and price transparency have reduced global prices, suppressing inflation—something a rule can't quantify.

"As part of its process to determine appropriate monetary policy, the FOMC consults rules such as the Taylor rule to see what they recommend," Neel Kashkari said in a WSJ op-ed. "But ultimately we use judgment and historical precedence to decide if that guidance makes sense given other important economic trends that rules don’t consider."

Rules based or not, current Fed officials do take the Taylor Rule into account, but inflexibly following a rule that consists of data that lags, is revised periodically and is prone to seasonal and one-off volatility, is a major flaw in rules-based policymaking. (See also: Central Banks' $13 Trillion Problem.)

In response, Taylor said Kashkari's blog titled "A Computer Can’t Do the Fed’s Job" failed to address the failures of Fed policy after the financial crisis, where it purchased large amounts of treasuries and mortgage-backed securities to shore up the banking system. "These policies were ineffective. Economic growth came in consistently below what the Fed forecast and much weaker than in earlier recoveries from deep recessions," Taylor said.

Ben Bernanke, who was Fed chair throughout the financial crisis, disagreed with Taylor's argument. Bernanke argued that the Taylor Rule using the Fed's preferred measure of inflation—PCE core inflation—would have sent the fed funds rate into negative territory in 2009, and left it below zero for six years.

Source: Brookings

The Bottom Line

Whether the Republicans pull a 180 with the Fed and appoint rules-based policy makers is yet to be determined, but it's not out of the question. Should this happen one will have to consider how a formula will decide how and when a $5 trillion balance sheet is to be reduced—something Trump and the GOP have called for swift action on. (See also: How Will the Fed Reduce its Balance Sheet?)

And should they go that route, they will have to sell it better than House Speaker Paul Ryan's did in 2015. "If the Federal Reserve explained to the public how it made its decisions, families could better plan for the future."